Equity Analysts: "In A Bull Market, You Don't Need Them. In A Bear Market, They'll Kill You"

From bull market gods and goddesses of the 1980s and 1990s, stock analysts now preside over a much more modest kingdom.  Nic Colas, of ConvergEx notes that the world has moved on to new golden calves, from currencies (with great leverage) to exchange traded funds (with generally less volatility) to macro analysts (the current Zeuses and Heras).  This even extends to the world of the retail investor – there are far more Google searches in the U.S. for "Storage auctions" (246,000/month) than for "stock research" (just 33,000/month), and the rate of decline resembles a fast-decaying radioactive particle.  Yet the rebirth of the business is already underway.  Analysts now focus on developing useful proprietary datasets, exclusive expert resources, channel-checking contacts, and deeper management relationships.  The public’s attention to active money management and stock picking will always be linked to overall market performance, but when the next bull market arrives those analysts who remain – and innovate - will be well-positioned to climb back to the top of the food chain.

Nic Colas, ConvergEx: Death (and Rebirth) of a Stock Analyst

Suppose for a moment that you are a money manager with just one client, whose investment more than covers your day-to-day expenses at your customary 2% management fee.  The catch to this happy arrangement is that this investor wants a 10% absolute return and will pull his capital if you do not achieve it.  On the plus side, he will keep the money with you for as long as you achieve this bogey.  Drawdowns don’t matter; just make 10%.  Oh, and the performance fee is 50% of anything over that target. 

One more catch – you can only use one external resource in your investment process.  Our mystery client wants you focused.  Your choices are:

  • Unlimited access to one major broker’s sell side research and investment conferences.
  • Top-customer status at one expert network of your choice.
  • All the quantitative research resources you would like.  The catch here is that you can only hire a few programmers to exploit this content.
  • Unlimited access to a top-tier macro research firm, with resources deep in every major central bank around the world.

In the current investment environment, the last choice is the lay-up answer.  With asset price correlations near 90% for a wide range of investment choices, the on-off switch to market direction sits in Washington, Frankfurt, Beijing, and other centers of political and central bank power.  The other choices would give you little insight here.  Even those brokerages with excellent macro research and alumni in high places don’t seem to be able to call the twists and turns of macro policy. 

That little case study is just one reason for the declining interest in single-stock research, especially in the United States.  There is, of course, the range-bound equity market of the last +10 years as well.  There is an old saying about analysts among the grey hairs of Wall Street: “In a bull market, you don’t need them.  In a bear market, they’ll kill you.”  And in a flat market, it seems, both apply.  A few datapoints to highlight the decline of stock research in American capital markets:

  • Most surveys of institutional investors – mutual fund and hedge fund managers, mostly – find that these major clients of Wall Street firms pay their brokers for management access far more than the insights of their analysts.  The most commonly surveyed percent of commissions for access to conferences and 1:1 meetings is 60%.  The buy-sell-hold recommendations, written reports and visits from analysts are collectively worth more like 20% of the commission pool.
  • Retail investors have a similar level of ennui at the moment when it comes to equity research.  If you look at Google Adwords search count data for the term “Stock Research” you’ll find that the average month only registers about 33,000 searches for the term.  Thanks to several reality TV shows, the term “Storage auction” – the business of buying abandoned storage lockers to resell their contents at a profit – gets 246,000 searches per month.  At the crudest level of comparison, this means the average American thinks wading through bedbug infested storage lockers is preferable to sorting out the winners and losers in their portfolios.
  • Google Trends data shows the rate of decline in the search for “Stock research,” and the decline since 2006 looks like some fast-decaying radioactive isotope.  Interest in the term saw a 50% reduction from 2006 to 2008, and a further reduction of like amount since then.  That essentially means that searches for the term now sit 75% lower than just six years ago.  By contrast, the search term “ETF” is exactly where it was in 2006, which may sound like a pyrrhic victory save the tough investment environment of the last five years.

It is, however, too soon to put the stock research business in the same receptacle as buggy whips, road atlases and the yellow pages.  First of all, brokerage firm analysts are the single most efficient billboards available for those companies’ thought leadership in a given sector. An analyst that “Shows well” to the firm’s investment clients and corporate customers is still a valuable franchise.  How else do you think all those management meetings come to be in the first place?

Even outside the narrow confines of brokerage research, enterprising independent analysts are remaking the single stock research game along a new set of parameters.  And some that aren’t so new, but have fallen into disrepair.  Some examples here:

  • Quantitative data sets and surveys.  When I first started as a stock analyst at First Boston in 1991, my mentor was a 20 year veteran named John McGinty who covered the machinery sector.  Every quarter he would call all the Caterpillar dealer around the world – there were about 350 at the time, I believe – and ask how business was going.  Sales trends, inventory levels, and the like.  He published the findings, which were always well received since no one else did the work. 

    The world has moved on a bit since those surveys.  Many U.S. listed companies take a dim view of analysts calling their store locations – even those that are franchised - or trying to wheedle information about of mid level executives.  And the Securities & Exchange Commission looks on such leaks with an equally discouraging eye. 
    Against those forces of containment you have the expansive push of technology.  Credit cards companies now have purchase data for hundreds of millions of consumers.  The Internet makes certain business models – think online booking of airplane tickets – entirely transparent to anyone who can ping travel websites every hour and look up the average seat cost for every flight.
    When you dovetail this newfangled way to collect information with an increasingly computer-based trading architecture in the U.S., the future of stock research and analysis comes into sharp focus.  While quantitative investors and high frequency trading operations currently have remarkably short-duration investment holding periods, there’s really nothing in their platforms that limits them to 15-second periods of stock ownership.  As more data about consumer spending and behavior goes online or into corporate data centers, that information will be sold to Wall Street.  It’s already happening.
  • Narrow industry focus/select distribution.  At ConvergEx we have a robust business promoting select research providers to institutional clients, and in this particular area the single-stock analyst is still welcomed – on their merits – into the investment workflows of hedge funds and long-only shops.  Prospective clients want to see a small client list (less than 20 is ideal), a definable edge (usually in health care or technology) and a strong compliance process.  Connect those three dots, and stock research is still alive and well on Wall Street.  The downside: those are three hard-to-connect dots.
  • Novel sourcing.  Imagine that you have a lead on a great investment opportunity in West Africa -  a new group of highly experienced mining professionals for the region has identified a promising new diamond field.  How do you tell if the managers are on the up-and-up?  You hire a team of ex-CIA and British intelligence officers to check it out.  In less than a week they can ping their resources in the region and given you a written report detailing everyone involved in the venture.  Where they went to school, any history of corruption, the whole ball of wax.  This won’t assure success, of course, but it does limit the possibility of fraud.

In short, stock research will make a comeback, and that return journey will likely come from two directions.  The first will be technological.  Any product that can systematically deliver quantitative business information in real-time to the increasing legions of automated trading systems and algorithmic investors will grow.  The second path is more cyclical in nature.  I can’t but think old-school stock research, with sector analysts, is ultimately tied to the fortunes of the equity market.  When those recover, interest in stock picking will as well.  And for analysts and stock market investors, that inflection point cannot come too soon.